This post started as a comment on HipMojo’s post Does Google Deserve to be Worth More than Wal-Mart or Toyota Corp?, but as the response passed 500 words I thought it warranted a post in its own right.
Market capitalization only represents the value of the equity of a company. The appropriate metric for comparing the value of companies is the enterprise value [EV]; using the EV accounts for the differences in capital structure.
Google’s (GOOG) EV is currently approximately $170 billion (Google’s EV is lower than its market cap due to the cash and cash equivalents on their balance sheet) compared to Wal-Mart’s (WMT) $220 billion. Wal-Mart is worth approximately $50 billion more than Google but the gap is closing. In the last financial year Google had revenues of $10.6 billion and EBITDA of $4.6 billion. The current price implies an EV/EBITDA multiple of approximately 34 for Google. Correspondingly, Wal-Mart had revenues of $348.5 billion and EBITDA of $26 billion. The current price implies an EV/EBITDA of approximately 8.3 for Wal-Mart. Care must be taken when comparing valuation multiples. The key reasons for Wal-Mart’s EV/EBITDA multiple being 25% of Google’s are that Wal-Mart does not have the same growth potential as Google and Wal-Mart’s significant capital expenditure (~$15 billion per annum). To answer the question whether Google deserves to be worth more than Wal-Mart or Toyota (TM) depends on whether Google’s current price is justified.
Google’s performance to date has been driven by AdWords (87% of net revenues in 2006). AdWords is an excellent business that generates great margins and still has significant growth potential. Two key factors in the success of the AdWords business model are the technology (Google’s search algorithm) and content (the web). Google’s focus on developing and refining its search algorithm in its formative years has resulted in it obtaining over 80% of the search market. The second factor in the success of the AdWords model is that the content is the web, which is effectively free; the free content drives the great margins generated by AdWords. Google will continue to dominate search at least until the next breakthrough in search technology and, depending on the nature of the breakthrough, they may still maintain the dominant position.
The success of AdWords has allowed Google to build an inventory of text ads
that they have been able to leverage through AdSense. The key difference with AdSense
is that the content is not free and Google must share this revenue with the 3rd
party sites, resulting in significantly lower margins. Google are looking to
broaden their ad serving capabilities with their Double Click acquisition.
Google’s current value is driven by expectations of the future online
advertising spend. This growth is being driven by the increasing amount of time
we are all spending online. The more people and more time spent online will
result in more searches for Google to monetize and more click-throughs on their
AdSense servings. A significant portion of the projected growth in the online
advertising spend is not paid search or contextual text ad placements. As
individuals consume more and more media online as opposed to traditional
mediums such as print and television the advertisers will follow. The question
is how much of this non-search advertising revenue Google can capture.
As Google builds its advertising inventory it is well placed to monetize
product lines such as Google Apps. The key difference between these
opportunities and search is Google doesn’t yet have the superior product and
faces significant competition. Google can still get a take a slice of the
action from third party products via AdSense but the margins are significantly
lower than if they were being served on Google
websites.
Google sites such as YouTube have potential to monetize
premium content but they are still developing an advertising model. The key
issue around Google’s potential non-search advertising revenues is the margins.
How much of the projected online advertising spend will end up at Google’s
bottom line? In other words, how much will Google have to pay to content
providers? The internet offers the ability to distribute content through one
channel to a far greater audience than print or television but will the cost of
this content as a percentage of revenue be any different in an online world
(this is the content cost not distribution costs)?
Google has the ability to serve ads around user generated content but unless this content is on Google websites the margins will be in line with those currently being achieved by AdSense.
The point of this is that Google’s AdWords business is a great operation. They are very well placed to capitalize on the increase in online advertising given their advertising inventory and ability to leverage users of their existing services. The two issues differentiating these opportunities from search are the absence of a technological advantage and cost of content.
Google’s current price is consistent with analysts’ estimates. These estimates are based on significant growth (22% EBITDA CAGR over the next 10 years and a terminal growth rate of 7%). I think Google’s AdWords business still has significant growth potential, and they are well placed to grow their non-search business, but I think the market is over pricing this growth potential and the current price does not fully reflect the potential for significantly lower margins in new business lines, competition in non-search segments and the general uncertainty as these new business models emerge.
